Time to take profits as auto parts sector shifts into lower gear

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Since the North American auto industry bottomed out in 2009, Canadian auto parts stocks have been on a tear, outperforming most of the car manufacturers themselves.

As the pace of growth in vehicle sales and production begins to moderate, now might be a good time for shareholders of those parts companies to take some profits on what has been a monumental rally.

"The problem is, they're very cyclical, so it's never wrong to lock in some profit, especially when they've done as well as they have," said Gavin Graham, chief strategy officer at Integris Pension Management.

Investors with the foresight to bet on Magna International Inc., Linamar Corp. and Martinrea International Inc. at the depths of the auto industry crisis have realized gains of 875 per cent, 380 per cent and 2,780 per cent, respectively.

Over that time, light vehicle production in North American nearly doubled to 16.1 million last year, the highest volume in 13 years.

This year, that number is expected to rise to about 16.7 million units – a respectable gain, but not quite the kind of giant leap forward the industry has been taking in recent years, such as in 2012, when 2.3 million more vehicles were produced than in the previous year.

"The pace of improvement is much slower," said David Tyerman, an analyst at Canaccord Genuity.

"There's nothing to say it will go down, but we're in the maturing phase."

Linamar, which produces engine and transmission components, Martinrea, which specializes in metal parts, and Magna, which does pretty much everything, are all, of course, vulnerable to a potential slowing of vehicle production.

"Having very high multiples at a point when things start to slow down to me is a flashing warning sign," Mr. Tyerman said. But he acknowledged that "it's hard to make that argument today for a company like Linamar coming off a fantastic quarter."

Last Wednesday, the Guelph, Ont.-based company blew the doors off of first-quarter forecasts, posting earnings of $1.22 a share, which beat the consensus mean estimate by 25 per cent. Linamar built market share, improved its balance sheet and increased its margins, while raising its estimates of future profit margins. Linamar stock rose by 12 per cent the following day, hitting a new record high.

Just three days prior, Mr. Tyerman had warned about valuations getting stretched in the auto parts sector, pointing to "BMW fundamentals and Ferrari valuations." Linamar was the leading source of concern, which has an enterprise value of 6.7 times Canaccord's estimated 2014 EBITDA, or earnings before interest, taxes, depreciation and amortization.

Even after the earnings beat, Mr. Tyerman maintains his view that the stock is richly valued.

"We think there is limited valuation upside potential," he said, claiming the stock is priced for a resilient auto sector and bears no hint of a production slowdown. The same rationale applies to Magna, Mr. Tyerman said.

Overall, the Street is still upbeat on the sector, but sees stock gains being more modest going forward.

The consensus target price on Magna is $109.85 (U.S.), while Linamar has an average target of $62.67 (Canadian), according to Bloomberg. The average price target on Martinrea is $13.29.

Martinrea, which while exposed to the same industry updraft, is up a comparatively paltry 18 per cent over the last year.

The company has grappled with the threat of a proxy battle, the departure of its CEO, operational issues, considerable capital expenditures and a big fourth-quarter earnings miss.

"On top of it, there is an element of skepticism around the results and around management, and that has definitely weighed on the stock," said Patrick Horan, a principal at Agilith Capital.

He sees Martinrea's margins recovering in the coming quarters and its stock catching up to Magna and Linamar. "We think it's a fast follower to the other two."